Summary

The evidence is mounting that the fundamental problem all along has been one of historic divergences within markets.

When divergences get extreme, the beginning of the convergence is equally as violent.

The good news is that finally market behavior is respecting history and this should result in a massive shift.

"Don't wait until you're in a crisis to come up with a crisis plan." - Phil McGraw

Following a second nasty week for stocks, the media is now beginning to ask if we are on the verge of a recession. Small-cap stocks (NYSEARCA:IWM) have entered "bear" territory after a 20+% drop off the highs. Recession or not? Bear market just starting, or simply on-going?

The evidence is mounting that the fundamental problem all along has been one of historic divergences within markets. Simply looking at headline averages belies this fact. All along, bear market behavior has been happening beneath the surface. All along, Utilities (NYSEARCA:XLU), Treasuries (NYSEARCA:IEI), and low beta stocks (NYSEARCA:SPLV) have continuously outperformed as small-caps, commodities, and emerging markets were in an on-going secular decline.

Those very same headline averages, over the last 10 trading days, had their worst first two weeks to start the year in history going back to 1928. When divergences get extreme, the beginning of the convergence is equally as violent. It is clear now with hindsight that the extent of the divergence headline averages have had with everything else is precisely why active strategies of every stripe, whether alternative, unconstrained, or sector wise have had such a hard time. When divergences persist for a long period of time, fragility increases.

The good news is that finally market behavior is respecting history and this should result in a massive shift away from passive return management to active opportunities. The bad news is that for asset allocators who have relied on passive indexing, this could get a lot worse before it gets better. The dilemma here is that unlike 2008 which was driven by a banking crisis, the Fed cannot bail out the Energy sector. The Fed can't also suddenly lower rates after having just raised them as that would result in a complete loss of credibility by the marketplace. It turns out, the deflation pulse is much more severe than originally thought.

The question of whether or not we are in an on-going bear market or one that has just begun is largely irrelevant when put in this context. The bigger question is how divergences resolve themselves. The biggest divergences are between stocks and inflation expectations, small-caps and large-caps, emerging markets and developed equities, and finally commodity levels and bond yields. We have written about these observations extensively for a long time now (click here to read). These divergences do not have to be resolved in a negative way. It is very possible in the coming months that inflation expectations rise, emerging markets melt-up, and commodities move higher pushing bond yields with them. The dilemma, however, is that inflation expectations (NYSEARCA:TIP), small-caps, emerging markets (NYSEARCA:EEM), and commodities (NYSEARCA:DBC) tend to lead ahead of everything else falling around it. Those areas have been sending warning signs for a long long time now. Either those areas were right in foreshadowing a bear environment, or the signals get exhausted and reverse.

Which plays out is unclear, but if Oil (NYSEARCA:USO) in particular continues its decent, we may be on the verge of another sector-driven crisis. The cure to low prices in commodities is low prices, but only to the extent that either supply collapses (through a crisis and mass bankruptcies), or there is a sudden surge of demand globally that lifts prices. The demand side looks problematic given the weight of the evidence against global growth and the clear ineffectiveness of any central bank to create lasting acceleration in anything except animal spirts for stocks. Credit spreads suggest the higher likelihood is a wave of defaults which cannot easily be assuaged.

One thing is clear - the low volatility regime outlier is ending, and this will be a violent year in both directions. That brings many opportunities for disciplined strategies which had a hard time in the last cycle, but may have a far better future in the new one that has just begun.

This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.

Disclosure:I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.